For the sake of completeness...
Q: Do I need to create a directory where to store these pictures?
Q: What should be the location of this directory?
It is not necessary to put the figures (or other files required for the typesetting of the document, as
bib files, etc...) into specific directories. This means that you can organize your files in a way that suits to you, and
latex and friends can be persuaded to adapt to your structure. It is just a matter of specifiyng the path unambiguously. Defining a relative path as Umar Kalim does in his answer is a good practice, minimizing both keystrokes and errors.
Q: What kind of file extensions do I need to have for these files?
If you want to include figures, you will probably want to use the
includegraphics command from the
graphicx package. If you specify the filename without extension, as in
eps extension will be added when compiling with
latex, and the
pdf extension will be added when compiling with
pdflatex (for this to work the two versions of the file should be present in the same directory).
The file types supported natively are:
latex: can include EPS files with
graphicx package (some
dvi viewers may fail to show the image though)
pdflatex: according to the manual page,
In PDF mode, pdfTeX can natively handle the PDF, JPG, JBIG2, and PNG graphics formats.
As stated in Umar's answer, with the
epstopdf package it is possible to include
eps graphics into
pdf files (the package automatically converts the file to
pdf format, so the tool
epstopdf needs to be present in your system)
If your file is not in any of these formats, it has to be converted to one of the above mentioned. Automatic conversions (i.e., performed by
(pdf)latex at compilation time) can be forced using the
\DeclareGraphicsRule command: take a look at Using macros in \DeclareGraphicsRule statement using shell command, Add tif image to LaTeX and related questions.